Rules of the Game: The Whys of Investing

 | Jan 10, 2014 | 2:00 PM EST
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The other day I wrote about the need to tilt toward small and value in the equity portion of your portfolio. Why? Because over rolling periods of five, 10, 15, 20 and 25 years, they perform better than their larger cousins.

Keep in mind: I'm not talking about single stocks. Au contraire! Trying to pick which single stocks will outperform some benchmark is speculating, not investing. And that's OK, as long as you carve out some small portion of your assets as your "play money" account. Because that's what it is.

So before I discuss how to allocate small and value, it's worth taking a minute to explore the whys of investing. Most people's knee-jerk response will be, "To make money!"

Meh. That's one of those smart-aleck responses that doesn't address the real reasons. You are investing to meet future liabilities. The most common reason is to meet your own income needs in retirement. Saying that you have X-amount of money in your IRA is meaningless. But saying that you have enough in your IRA and other brokerage accounts to have an income stream of, say, $75,000 per year -- now that is meaningful.

There are other situations where it's crucial to have an expected return from your investment portfolio. Those include leaving something to your children or grandchildren, or being able to insure yourself for long-term care or end-of-life health care needs.

That stuff is just a little more important than whether 3D Systems (DDD) or FleetCor Technologies (FLT) is finding support at some moving average, isn't it? When you think about it like that, you realize that it's not even in the same league.

(And trying to gauge an expected return from a batch of single stocks is a futile exercise. Expected returns can be calculated from asset classes and allocations – not just because you believe Facebook (FB) is a "monster stock." The why of speculating on Facebook would be to have some fun, hopefully make some money, and have bragging rights if you bet correctly.)

Index investing is not a bad first step toward a systematic approach toward portfolio construction. But you have to be cognizant of which indices you are using, and why. Even index investing can be used incorrectly, if it turns into a sector bet.

There's an important distinction between betting and allocating. Tilting toward small and value will ultimately, over time, boost your returns more than if you tilt toward large and growth. However, that doesn't mean you want an investment portfolio that only consists of small and value. Asset classes move in different directions at different times, and it's impossible to consistently predict which will shine in any given year.

You want to choose baskets of stocks that give you small and value exposure, both domestically and internationally. Naturally, you'll want to look for low expense ratios, and steer away from any sector funds or country/region funds. For example, when looking at emerging market funds, avoid something that concentrates on Brazil or China, or even Asia. Look for a low-cost fund that gives you exposure to the entire emerging-market asset class.

I'm not suggesting that you overlook other asset classes, such as U.S. large-cap, REITs or fixed income. It's important to have diversification in the right proportions.

I'll continue this line of thought in my next column, but I want to leave you with a closing idea when it comes to portfolio balance: If all your investments are moving in the same direction, at the same time, then you have a bet, not allocations.

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